Economy minister Richard Bruton said Ireland had become "caught up" in the problems of other weaker members of the eurozone, and that the country was on track to hit the targets agreed with the International Monetary Fund (IMF). He also admitted that the downgrade will hurt Ireland's ability to rebuild its economy.

"This means for certain investors, Ireland is now taken off their radar, they will not touch Irish borrowings, that is bad for us, that makes the whole job of recovery more difficult," said Bruton.

"It is important to say this is agencies looking at a European strategy and we have been caught up in their view of the European solutions," Bruton added.

Investors drove down the value of Ireland's sovereign debt on Wednesday morning, driving up the yield – or interest rate – on the Irish 10-year bond above 14%. There was some relief for Spain and Italy, whose yields fell back to 5.7% and 5.4% respectively.

Moody's justified the one-notch downgrade, to Ba1, on two counts – the weak Irish economy, which it said undermines the effectiveness of the government's fiscal plan, and the increased likelihood that any subsequent rescue package would include losses for private creditors.

"Even the perception of possible private sector participation in a future funding package impairs the ability of the Irish sovereign to regain access to private markets in the near term," said Davy's Conall Mac Coille.

The Irish government has also argued that Moody's downgrade, which came late on Tuesday, was "completely at odds" with other rating agencies' views.

It also said it did not reflect the progress made at last night's eurogroup meeting where the minister of finance Michael Noonan is believed to have edged closer to a deal to get the country's "punitive" interest rate on the bailout reduced in a move that could save the country over €200m (£176m) a year.

"This is a disappointing development and it is completely at odds with the recent views of other rating agencies. Just last week, Fitch & DBRS noted our economy's return to growth in the first quarter, the progress in reducing our budget deficit and said that there was no reason to alter their views on Ireland at this time," said a spokesman for the department of finance.

"Given the timing of the Moody's announcement it is difficult to see how its decision reflects the agreement reached at last night's eurogroup meeting to enhance the flexibility and the scope of the European financial stability facility (EFSF), and to lengthen the maturities of, and lower the interest rates on, loans to countries in receipt of financial support," she added.

The cost of insuring Irish debt rose on Wednesday, as traders reacted to Moody's downgrade.

"The one-notch cut to Ba1 wasn't a tremendous surprise given the action on Portugal last week, and Ireland has been trading equivalent to a junk credit for many months," said Gavan Nolan, director of credit research at Markit.

"Nonetheless, it could trigger some forced selling in the bond market and can only add to negative sentiment."

The European commission said it "regrets the decision of Moody's to downgrade Ireland". It said it was confident Ireland was on track for a recovery and the decision "contrasts very much with the recent data, which support a return to GDP growth this year".

The European commission added that Ireland was making a "determined implementation" of the bailout programme and the Irish government had taken "strong ownership" of the necessary austerity programme.

IMF on the way

The Moody's decision is a particular blow to the government, which is expected to get a good school report on Thursday from the IMF and EU, who will hold a press conference outlining how Ireland has met all fiscal targets under the IMF/EU programme.

They are also expected to say that Ireland is on track to achieve the deficit reduction for the year as a whole.

The head of the IMF's mission to Ireland, Ajai Chopra, has been in Dublin for a week leading the review of the second quarter performance.

In a note today, Dublin stockbrokers Bloxham said Moody's decision would force some investors who were permitted to hold non investment-grade status stock to sell.

"In our view this latest move by Moody's is cynical and manipulative, coming just two days before the EU/IMF in their latest quarterly review are expected to give Ireland the thumbs-up in meeting all its bailout targets," it said.

"The bottom line is that the credit ratings agencies have far too much power but policymakers and regulators only have themselves to blame."

Only last week Moody's said it saw differences between Ireland and Portugal when it downgraded the latter's debt to junk status.